On market timing… Part 1: Point in Time Market Timing.

A recent Dan Solin article opined “Don’t try to time the market by bouncing in and out of stocks and bonds.”

This reminded me of a detailed market timing analysis I provided in my 2008 Capitalism in Crisis 3 report.   I am breaking this analysis down into a number of parts as follows:

In practical terms, market timing per se is a marginal investment activity. This does not mean that investors should not be engaged in some form of structured adjustment to asset allocation during periods of market excess, or that risk and hence valuations do not move to extremes; this document does not believe that markets can efficiently price risk at all points of the market and economic cycle, for a number of reasons. There is also a big difference between arbitrage, market timing and structured adjustment to asset allocations based on liability profile (the economic imperative); arbitrage and structured adjustment are both valid and necessary.

At any one point in time there is only so much money in the economy; part of this money is allocated towards transactions and expenditure and part towards money holdings in individual and institutional portfolios.

If investors want to increase, en masse, the amount of money they hold, and reduce the amount of equities they hold in their portfolios, all they can do is reduce the value of equities to the point that the amount of cash they hold as a percentage of their portfolio increases.

Let us assume, that in the market portfolio (the sum of all investors holdings) there is 10% cash, 30% fixed interest and 60% equities[1]. The following table shows the impact of investors attempting to increase their cash holdings as well as reducing their equity holdings.

Table 1[2]

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Column 1 shows the nominal dollar amount of money in the market portfolio (the sum of all individual portfolios), column 2 the dollar value of bonds, and 3 the dollar value of equities.

Column 3 shows the impact of marginal changes in demand for money and equities, on the value of equities in the portfolio and column 4, the total value of the portfolio. All transactions happen between cash and equities.

Column 5 shows the allocation to money as a percentage of the portfolio, as the market attempts to increase or decrease cash holdings. Since the amount of money supply in an economy is fixed at any one point in time, the market, as a whole, cannot increase/decrease the amount of money it holds by selling equities. All the market can do, is reduce/increase the value of equities. In this example, there is no change in demand for bonds; all we are doing is assessing the impact of market timing between cash and equities – the impact of changes to bond allocations are discussed in section 2.3.

If the market wants to increase cash holdings from 10% to 10.5% of the portfolio, the stock market will need to fall by 8%. A preferred 2% increase in cash holdings, as a percentage of the market portfolio, results in a market correction of 28%. An attempt to increase the cash allocation to 20% would see an 83% fall in the market. The impact of changes in relative demand on individual stocks and sectors is even more pronounced, and illustrates how stocks, sectors and market cap components can easily become significantly under and over valued.

On the other hand if allocations to asset classes remained the same, a 7% increase in money supply would see a 7% increase in asset prices. As such, short term changes in risk preferences have a much greater impact than annual increases in money supply.

This analysis should also be of interest to those that use linear models to determine mean/variance efficient portfolios. The simple analysis used in the MVA model does not adjust for the impact of changes in asset allocation, due to changes in monetary demand, on risk/return relationships. Effectively these mean variance models are models of individual portfolio allocation and not a market portfolio model.


[1] This is a simplifying assumption since, for example, the US debt markets exceed the value of the US equity markets. A lower equity allocation actually exacerbates the results of the analysis increasing the impact of changes in cash holding preferences on the value of the equity market.

[2] Inspiration for this type of analysis is originally drawn from Professor Tim Congdon’s essay for Institute of Economic Affairs: Money and Asset Prices in Boom and Bust – http://papers.ssrn.com/sol3/papers.cfm?abstract_id=839866

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